How to Profit From Falling Stock Prices?
As we come into year end you might be lucky enough to have significant unrealised profits in your portfolio. You may also be unsure of what next year holds for stocks as inflation takes hold and central banks come under more and more pressure to raise interest rates or at least remove QE. Maybe, you do not want to realise a capital gain in this financial year.
The sudden and rapid fall in stock prices on thanksgiving Friday may cause you concern. Maybe you do not want to ‘short’ stocks but would like a safer way on how to profit from falling stock prices?
The Bear Put Spread is a great way for you to profit from falling stock prices.
- Cost of the trade is small
- Risk is limited to the amount you invest
- Profit potential is significant
Let’s use an example with SPY (the ETF that tracks the returns of the S&P 500). Recently it hit its all time high of $473 and has pulled back slightly to $458.97. Let’s pretend that you see further downside over the next 2 weeks to SPY and believe that it could fall to $440. This would represent a 7% fall from it’s all time highs which is not unreasonable given the risks cropping up with the Covid 19 variants Omicron.
Note: Before I go on please note that we have a full online course on this strategy in our members area. You can take a free trial and complete the course if you wish.
The Bear Put Spread
You could look at the Dec 10th (12 days from now) expiry for SPY and place the $450/$440 bear put spread at a cost of $150 per contract (1 option contract controls 100 shares). Let me break this down in simple language:
- There are two parts of the trade:
- Trade 1: You are buying insurance on 100 shares of SPY at the $450 strike which basically allows you to sell 100 SPY anytime between now and Dec 10th at $450. This means if SPY fell to $400 you could actually still sell the shares at $450 because of this insurance policy.
- Trade 2: You are selling insurance on 100 shares of SPY at the $440 strike which basically means that you have insured someone else’s shares at $440. This means that if SPY fell to $400 for example you would be obligated to buy someone else’s shares at $440.
- The Combined Trade: With both trades combined you now have the right to sell 100 shares of SPY at $450 and the obligation to buy 100 shares of SPY at $440 before Dec 10th (12 days from now). The cost of this trade is $150.
Potential Outcomes at December 10th:
What are the potential outcomes for this trade? It is a bearish trade and we want the stock price to fall. Here are three potential scenarios with the profit or loss for each scenario:
- If SPY Falls below $440: Excellent! We will make full profit. A simple way of looking at this is as follows: We get to buy 100 shares at $440 and sell them at $450 for a $10 per share profit per share. We bought and sold 100 shares which equals $1,000 minus the $150 cost of the trade which equals a $850 net profit. The total return on investment for this trade is 566%!
- If SPY drops between $440 and $450: We could make a partial profit or a partial loss depending on what price SPY closes at.
- Let’s say SPY closes at $445. A simple way of looking at this is as follows: We buy 100 shares at $445 and sell them at $450 for a $5 per share profit per share. We bought and sold 100 shares which equals $100 minus the $150 cost of the trade which equals a $350 net profit. The total return on investment for this trade is 233%!
- Let’s say SPY closes at $449. A simple way of looking at this is as follows: We get to buy 100 shares at $449 and sell them at $450 for a $1per share profit per share. We bought and sold 100 shares which equals $100 minus the $150 cost of the trade which equals a $50 net loss. The total return on investment for this trade is -33%!
- SPY stays above $450: We will make a full loss of $150. A simple way of looking at this is as follows: it makes no sense for someone to sell us their shares at $440 since they can sell them in the open market for a higher price. Plus the value of our insurance policy is also worthless since the share price of SPY is above the insured price of $450. Therefore both contracts expire worthless and we lose our investment.
The Bear Put Spread offers you a low cost way of profiting from falling stock prices, it also offers you a low cost way to protect profits in a portfolio.
If you would like to know more about this strategy feel free to take a free trial of our stock market courses, we have a full course on this strategy which you can complete during your trial.
Happy Investing
Stephen
Head Trader
Share Navigator